How to keep final salary plans open

As many employers are closing final salary plans due to costs, Nick Golding looks at ways to retain them

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With the majority of defined benefit (DB) pension schemes now either fully or partly closed to employees, the previously-generous benefit is fast becoming the stuff of legends.

Just how much the benefit has declined in popularity among employers is evident from Aon Consulting’s 2007 Pensions under control research, which shows that only 27% of UK employers offering DB schemes now provide them to both existing members and new employees, compared with 50% in 2003.

The spiralling cost of running a DB scheme is a major factor behind their decline, as employers typically can’t afford to fund a plan that results in individuals recieving a pension based on their final salary for up to thirty years after retirement. Consequently, a number are looking for ways to retain the benefit but reduce the costs involved.

Kathryn Armistead, senior consultant at Watson Wyatt, explains: “What many employers are saying is ‘we don’t want to close our DB scheme but we may make some changes around accrual rate and retirement options [to control costs]’.”

Removing some of the more generous features of a DB scheme is one way employers can make it cheaper to run. Some plans, for example, traditionally offer attractive retirement options, such as early retirement, which should be the first to get the chop. “A typical DB scheme may allow employees to leave the company at [age] 60 [years] with no reduction in their pension, which is very generous. Some [employers] have decided to remove benefits that were previously given,” explains Armistead.

Others are putting pressure on DB members to pay higher costs for being part of a plan. By doing so, employers can reduce their contribution rates and save money on the overall cost of providing the benefit. In some instances, where organisations previously provided non-contributory DB schemes for staff, the employer has asked DB members to start contributing if they wish to remain in the plan.

Paul McGlone, principal and actuary at Aon Consulting, says: “Between 2000 and 2005, I would say that about two-thirds of DB schemes changed their contribution levels. Many non-contributory schemes have also started to ask for contributions, modest ones to begin with.”

He adds that increasing employee contributions means the day-to-day cost of running the scheme is reduced, as it is shifting some of the burden across to the employee.

Unilever UK opted for this course of action in January this year, raising the contribution rates for employees who wanted to remain in the scheme to 7%, up from 5%. Nigel Biggs, head of UK pensions at the consumer products firm, explains: “The move means that the employee has a reduction in his or her take-home pay because he or she is having to pay a higher contribution to be in the pension scheme.”

Career average schemes
Another cost-cutting exercise is to switch from a traditional final salary model to a career average DB pension. Whereas the final salary pension benefit uses a formula that acknowledges an employee’s last and typically highest, pre-retirement salary at an organisation, a career average scheme calculates the pension for an individual using their average earnings during their time with their employer. This will typically result in a lower pension for organisations to pay out.

Broadcaster ITV, the Home Office, Royal Mail and the BBC have all explored this course of action, and have either made the switch for all members or just new members, or are intending to do so. According to the Employee Benefits/Axa SunLife pensions research 2007, however, this option is not yet common practice among employers. Just 3% of respondents with a DB scheme said they had moved to a career average scheme, while another 3% said they planned to do so.

A less common route that some employers have taken in order to cut DB costs is linked to the life expectancy of staff. This involves the employee and employer agreeing a length of retirement for the retired worker, and a DB scheme then being offered to accommodate this timescale. If the employee then lives beyond his or her expected age, a formula is put in place to scale down the individual’s benefit, which reduces the risk associated with employees living longer and placing financial strain on the DB fund.

“This is basically the company saying, ‘we’ll offer you a DB scheme but only if your life expectancy pans out as expected, if it increases by 10% for instance, the benefit will reduce,” explains Armistead.

Tweaks to DB schemes can also be made when the benefit is in payment and some employers are finding value in reducing the rate at which pensions increase year on year. Currently, employers make annual increases to a retired employee’s DB pension in line with inflation. The statutory minimum amount that the pension is increased by is capped at 2.5%, although employers can increase this to make the scheme more attractive to staff.

The Association of Consulting Actuaries (ACA) has now put forward a proposal for conditional indexation to take this a step further and remove the cap altogether. This would allow employers to control when they raise the pension payments, so increases can reflect the organisation’s performance.

The ACA believes that if the government does not implement conditional indexation within the Pensions Bill, which is currently at committee stage and is awaiting its third reading in the House of Lords, there will be negative consequences for the benefit.

Ian Farr, chairman of ACA, explains: “The government may try to stall on this, but there is no time. This [conditional indexation] is a stepping stone to the future and if we wait there will be no final salary schemes left.”

Whatever changes employers make to their DB scheme, however, they must be careful to manage how this is communicated to staff to mitigate any potential disappointment or upset. Chris Bellers, pensions technical manager at Friends Provident, explains: “If an employee is expecting to retire on £20,000 [per year] and then they find out that their pension actually works out to £15,000 they obviously won’t be very happy about it.”†

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Case study: Unilever sets clear objectives for plan

Unilever UK, which closed its final salary pension scheme to new employees in January 2008, has clear objectives for the plan.

At the same time, it also reduced the minimum amount by which it increases pensions in payment from a 5% cap to 3%. However, this cap is still above the 2.5% minimum set by the government.

Nigel Biggs, head of UK pensions at the consumer products firm, explains: “Our objective is to provide a competitive pension package for staff and to do that in a way that is sustainable for the business. Once the employee has retired and the pension is in payment, if inflation is running at above 3% then they will get potentially lower increases because we have lowered the cap from 5% to 3%.” However, this change only affects staff who are building up their pension fund after January 2008.

The firm has also raised staff contribution rates from 5% to 7%.

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Ways of saving final salary pension schemes

Career average
Change the pension formula from one that is based on the employee’s final and highest salary figure, and move to a calculation that uses an average salary figure.

Reduce benefits
Strip out generous features of defined benefit (DB) plans, such as early retirement options, with no reduction to an individual’s pension.

Increase staff contributionsAsk more of employees. Some schemes require small contributions from staff and, in some instances, no contributions are made at all. If staff pay more, employers can afford to pay less.

Link DB to life expectancyAn individual’s pension can be linked to life expectancy, so those living beyond an agreed age will receive a reduced pension in payment.